On
ground of assurance of the return, there are two kinds of Investments
- Riskless
and Risky.
Riskless investments are guaranteed, but since the value of a
guarantee is only as good as the guarantor, those backed by the full
faith and confidence of a large stable government are the only ones
considered "riskless." Even in that case the risk of
devaluation of the currency (inflation) is a form of risk
appropriately called "inflation risk." Therefore no venture
can be said to be by definition "risk free" - merely very
close to it where the guarantor is a stable government.
Types
Smart
investing includes risk management. For each stock, bond, mutual fund
or other investment you purchase, there are three distinct risks you
must guard against; they are business risk, valuation risk, and force
of sale risk. In this article, we are going to examine each type and
discover ways you can protect yourself from financial disaster.
Investment
Risk 1: Business Risk - Business risk is, perhaps, the most
familiar and easily understood. It is the potential for loss of value
through competition, mismanagement, and financial insolvency. There
are a number of industries that are predisposed to higher levels of
business risk (think airlines, railroads, steel, etc).
The
biggest defense against business risk is the presence of franchise
value. Companies that possess franchise value are able to raise
prices to adjust for increased labor, taxes or material costs. The
stocks and bonds of commodity-type businesses do not have this luxury
and normally decline significantly when the economic environment
turns south.
Investment
Risk 2: Valuation Risk - Recently, I found a company I
absolutely love (said company will remain nameless). The margins are
excellent, growth is stellar, there is little or no debt on the
balance sheet and the brand is expanding into a number of new
markets. However, the business is trading at a price that is so far
in excess of it’s current and average earnings, I cannot possibly
justify purchasing the stock.
Why?
I’m not concerned about business risk. Instead, I am concerned
about valuation risk. In order to justify the purchase of the stock
at this sky-high price, I have to be absolutely certain that the
future growth prospects will increase my earnings yield to a more
attractive level than all of the other investments at my disposal.
The
danger of investing in companies that appear overvalued is that there
is normally little room for error. The business may indeed be
wonderful, but if it experiences a significant sales decline in one
quarter or does not open new locations as rapidly as it originally
projected, the stock will decline significantly. This is a throw-back
to our basic principle that an investor should never ask "Is
company ABC a good investment"; instead, he should ask, "Is
company ABC a good investment at this price."
Investment
Risk 3: Force of Sale Risk - You’ve done everything right and
found an excellent company that is selling far below what it is
really worth, buying a good number of shares. It’s January, and you
plan on using the stock to pay your April tax bill.
By
putting yourself in this position, you have bet on when your
stock is going to appreciate. This is a financially fatal mistake. In
the stock market, you can be relatively certain of what will
happen, but not when. You have turned your basic advantage
(the luxury of holding permanently and ignoring market quotations),
into a disadvantage.
If
you had purchased shares of great companies such as Coca-Cola,
Berkshire Hathaway, Gillette and Washington Post at a decent price in
1987 yet had to sell the stock sometime later in the year, you would
have been devastated by the crash that occurred in October. Your
investment analysis may have been absolutely correct but because you
imposed a time limit, you opened yourself up to a tremendous amount
of risk.
Systematic
risk and unsystematic risk
Systematic
Risk
The
risk inherent to the entire market or entire market segment.
Also known as "un-diversifiable risk" or "market
risk."
Interest
rates, recession and wars all represent sources of systematic
risk because they affect the entire market and cannot be avoided
through diversification. Whereas this type of risk affects a broad
range of securities, unsystematic risk affects a very specific
group of securities or an individual security. Systematic
risk can be mitigated only by being hedged. Even a portfolio of
well-diversified assets cannot escape all risk
Systemic
risk
is a specific term used in finance; it means the market risk or the
risk that cannot be diversified away, as opposed to "idiosyncratic
risk", which is specific to individual stocks. It refers to the
movements of the whole economy. Even if we have a perfectly
diversified portfolio there is some risk that we cannot avoid and
this is the systemic risk. However, the systemic risk is not the same
for all securities or portfolios. Different companies respond
differently to a recession or a booming economy. For example, think
of the automobile industry compared to the food industry in case of a
recession. Both of them will be affected negatively but food industry
not as much as automobile industry.
In
insurance it is difficult to obtain financial protection against
"systemic risks" because of the inability of any
counter-party to accept the risk. For example it is difficult to
obtain insurance for life or property in the event of nuclear war.
The essence of systemic risk is therefore the correlation of losses.
"Systemic Risk" adds the important problem that it is much
more difficult to evaluate than "specific risk". For
example, while econometric estimates and expectation proxies in
business cycle research led to a considerable improvement in
forecasting recessions, data on "Systemic Risk" is often
hard to obtain, since interdependencies and counter party risk on
financial markets play a crucial role. If one bank goes bankrupt and
sells all its assets, the drop in asset prices may induce liquidity
problems of other banks, leading to a general banking panic. One
concern is the potential fragility of some financial markets. If the
participants are trading at levels far above their capital bases,
then the failure of one participant to settle trades may deprive
others of liquidity, and through a domino effect expose the whole
market to systemic risk.
Unsystematic
risk
The
return from a security may some times vary because of certain factors
affecting only the company issues security.eg: are raw material
scarcity, labour strike, management inefficiency etc. when
variability of return occurs because of such firm-specific factors,
it is known as unsystematic risk .this risk is unique or peculiar to
a company or industry and affects it in addition to the systematic
risk affecting all securities
Types
- Business risk – is a function of the operating condition faced by accompany and the variability in operating income caused by the operating condition of the company.
- Financial risk - it is a function of financial leverage which is the use of debt in the capital structure. It is an avoidable risk. The variability in EPS due to the presence of debt in capital structure of a company is referred to financial risk.
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